China's Supreme Court has ruled custodians cannot hold shares in insurance firms on behalf of other companies because of the risk such arrangements pose to the financial system.

The ruling could rein in a rampant practice that has allowed entities to hide their controlling interests in insurance firms in an effort to avoid regulatory scrutiny and finance their own risky expansions with money raised from the public or policyholders, reports Caixin.

The case focused on shares of an insurance company that construction materials trader Fuzhou Tiance Industrial said that it had hired Fujian Weijie Investment to hold on its behalf in 2011.

In the case, Tiance Industrial accused Weijie Investment of refusing to return 20 million shares of J.K. Life Insurance in violation of a custodian agreement between it and Weijie Investment. The two companies also had a dispute over another 20 million shares of the insurance company.

In its defence, Weijie Investment argued that it found out after the agreement was signed that Tiance Industrial was not the real owner of the shares in dispute. Essentially, the case involved a complicated web of transactions that left open questions about who actually owned the shares in dispute.

In 2014, a provincial court sided with Tiance Industrial, upholding the agreement. In March, however, the Supreme People’s Court overturned the provincial court’s ruling and annulled the custodian agreement between the two companies.

The supreme court ruled against Tiance Industrial because it determined that share custodian agreement was never valid in the first place because of the danger it poses to the public.

“Allowing anonymous holding of shares of insurance companies … will inevitably expose the insurers to greater risk and undermine the healthy development of the industry,” the supreme court said in its verdict.

“The potential risks that the insurance companies are exposed to could put financial order and social stability at stake under some circumstances and in turn harm the public interest because the insurance industry affects the vital interests of numerous insured people,” it said.

In March, the insurance regulator limited the ownership of an insurance firm by each investor to no more than one-third of the insurer's total shares. The rules aim to prevent controlling shareholders from misusing insurance company funds for their own benefit.

But the administrative ban has not been supported by all Chinese courts, and some judges have recognised the validity of shared-custodian agreements.

Precedent

The supreme court’s ruling set a precedent for future cases involving disputes of shares held by custodians and it is expected to discourage investors from hiding their ownership through such agreements, analysts said.

“The judgment by the supreme court means that the widely existing custodian holding of insurance companies’ shares is not protected by law,” a lawyer with Beijing-headquartered Zhong Lun Law Firm told Caixin.

An official with the China Banking and Insurance Regulatory Commission who declined to be named said the ruling showed that the “administrative practice (of banning such custodian agreements) has received judicial support.”

Custodian shareholdings are extremely difficult to be identified unless they are reported by whistleblowers or become public in disputes between the investor and the custodian, the official said.

Consequently, the supreme court’s ruling could also increase the chance that these deals will come to light, such as in cases in which a dispute arises because a custodian refuses to follow instructions from the investors on the grounds that their shareholding agreement is invalid, legal experts said.